Long trades vs. short trades: which should I use?

Long trades vs. short trades: which should I use?
Table Content
The difference between long trade and short trade
How does it work?
An example
How to short a position
Managing risk as a trader
Stop loss order
Other limiting orders
Bottom line

Traders hear the terms “long trades” and “short trades” all the time, but beginners can find these a bit perplexing. For many investors, the difference between long and short trading could come down to how “bullish” or “bearish” they feel about the market. You can choose to go long (purchase) when you have evidence to believe that the market price of an asset will rise or go short (sell) if you believe it will fall. Investors usually engage in short and long trades to try and create consistent profits and a positive growth trend. Let's dive in a bit deeper. 

The difference between long trade and short trade

A long trade is a conventional investing strategy where you “purchase” an asset with the expectation that the price would increase in the future, at which point you can sell it and make a profit. On the other hand, a short trade is a more adventurous investing strategy that involves “borrowing” and selling an asset with the expectation that the price will decrease. 

How does it work?

Long trades follow a “buy low, sell high” idea with the possibility of unlimited potential profits as there is no upper limit on the price of the trading asset, i.e., securities held by brokers. In contrast, potential losses are limited as the security price can fall no lower than $0. 

For instance, you will go long on XYZ stock by purchasing 1,000 shares at $10 each at the cost of $10,000. If you sell them when the price increases to $10.50 per share, you will make a profit of $10,500. To long a position, you will need enough money to pay for the shares and broker commission.

Short trades are slightly more complicated than long trades. This entails borrowing a security whose price is likely to decrease and sell that security in the open market. Next, you will buy back the security once its price has dropped below the price you originally sold it at and pocket the difference. Then you will return the security to the broker. 

An example 

For example, let’s say ABC stock is trading at $50 a share. You short 100 shares of ABC by borrowing them from a broker and selling them in the open market for $5,000. The share price falls to $30, at which point you buy 100 shares to replace those you borrowed, netting $2,000 and closing your short position. If the price of the stock rises, traders who purchased it at a higher price will incur a loss. The greater the decline in the price of the security from the time it’s sold, the greater the profit to the investor.

How to short a position 

To short a position, you will need to post what’s known as an “initial margin”, a specific amount into your account to act as a buffer should the investment lose value. This means that you would have contributed some of your own funds, in the beginning, to accommodate for any losses. The amount will still belong to you, but it will be held as collateral by the broker to ensure that you will buy back the share in the future. Further, you will be responsible for what is known as “margin calls”, a process that occurs when the margin becomes insufficient, and you receive a call to replenish your cash buffer since there is no more wiggle room in the account to accommodate further losses. 

Managing risk as a trader 

Investors are usually hesitant about short trades due to their infinite risk, i.e., how safe your money will be. Potential profits in short trades are limited as the price of a security can fall no lower $0, and potential losses are unlimited because there’s no upper limit on the price of a security.

Stop loss order

Many investors attempt to limit the downside risk of their investments by using stop-loss strategies, the most common of which is the stop-loss order. Stop-loss orders are instructions to brokers on behalf of investors that are intended to protect profits, prevent losses, and eliminate emotional investment decisions. 

In short trades, stop-loss orders provide a specific price above which a security will be purchased. In long trades, stop-loss orders are standing orders to a broker to liquidate when a security’s price crosses a pre-specified threshold to partially mitigate risks. By closing out the position, the investor is hoping to avoid further losses.

An 11-year study by researchers at Lund University found that stop-loss strategies positively impact both expected and risk-adjusted returns. The study found strong indications of the stop-loss strategies being able to outperform the buy-and-hold portfolio strategy, especially in terms of risk-adjusted returns.[1]

Other limiting orders

Another way to limit losses, whether you choose long or short trades, is hedging, normally used alongside other strategies to reduce risk and maximize profits no matter which way the market moves. 

Hedging consists of two parts, the initial trade (long or short based on where you think the market is going) and your backup position (your strategy to reduce risk in case the market ends up going in the opposite direction). This is done by adding investments to your portfolio that move in the opposite direction of what we are trying to manage. This will ensure that if your security loses value for any reason, be it a specific stock or a rise in interest rate, the new security will appreciate and thus offset the decline – providing protection from sudden market changes and other risks. 

According to a recent survey by the American Association of Individual Investors gauging investor sentiment, investors lean on individual stocks and exchange-traded funds to hedge the risk of rising interest rates, volatility or socio-economic crises. Ninety-one percent of the group surveyed is holding stocks in their portfolio, and 75% is invested in ETFs

Bottom line

It's recommended that investors should go long on securities they believe will rise in the future and this has been a good investment strategy for a long time for some. Going short on stocks can also be profitable, but you should remember that this process carries more risk. Either way, make sure to do your research before going long or short. 

Share article
bg
google
apple
eth
bitcoin
eur
tesla
Connecting communities through education
app
app